A national sales tax is coming

The national debt, though huge, isn’t a problem right now, which is why Republicans who claim to be budget hawks are willing to borrow another $1.5 trillion over the next decade to give tax cuts to most businesses and some households.

But at some point, the United States will have to reduce annual deficits that could swell to $1 trillion per year as early as 2019. Republicans would prefer to solve that problem by cutting social spending. But that seems unlikely. To make a difference, cuts in programs such as Social Security and Medicare would have to be vast, which would outrage voters.

A more likely solution is a national consumption tax, otherwise known as a value-added tax, or VAT. “A 5% VAT would raise an enormous amount of money,” says Jeremy Scott, a tax attorney who is vice president of editorial at the publisher Tax Analysts. “The next major fiscal crisis might be followed by a VAT.”

Barring surprises, this could be some ways off. The economy is healthy now and there’s no sign of an imminent recession. The GOP tax cuts could boost growth, a little bit, for a couple of years once they go into effect.

A recession will spur government to boost revenue

But we’re also in the later stages of the business cycle, with a recession inevitable sooner or later. And Washington’s flexibility to respond to a downturn narrows as the national debt grows. The national debt is now $20.5 trillion, which is 103% of GDP. Economists used to think this much debt was unsustainable — but they turned out to be wrong. If there were a problem, investors would show reluctance to purchase Treasury securities, pushing interest rates up. Credit ratings on U.S. debt might fall, with a whole cavalcade of ugly ramifications if investors really began to doubt Washington’s ability to pay what it owes. None of that has happened.

But it would be foolish to assume it never will. The U.S. pays about $250 billion per year in net interest costs to finance all that debt. And that’s with long-term rates of just 2.4% or so right now, close to record lows. If rates headed back toward historical norms of around 7%, borrowing costs would rise, cutting into money spent on defense, roads, bridges, education and everything else Uncle Sam funds.

The Federal Reserve can help keep interest rates down, but only if inflation is low. If inflation picks up, the antidote is raising interest rates. And the Fed itself has expressed confusion about why inflation has stayed so low more than eight years into an economic recovery.

If there’s an urgent need to narrow federal deficits in the future, it will probably follow a recession in which there will be the usual political pressure for Washington to stimulate the economy through additional spending and an expanded safety net. That typically causes bigger deficits at a time when fewer people are working and less tax revenue is coming in. The last recession, which began in 2007, caused that sort of double-whammy, which led to the first-ever trillion-dollar budget deficit in 2009. The same thing could easily happen again.

Raising other types of taxes

The pinch could come as the national debt becomes larger and larger as a share of GDP, causing concern that Uncle Sam is in over its head. Congress could raise other types of taxes, of course, such as regular income taxes on businesses and individuals. But a VAT might actually be a better idea, because it can raise a lot of revenue without directly discouraging business investment.

House Republicans actually proposed a tax similar to a VAT in the tax plan they introduced in 2016, and carried into 2017 as the starting point for the Trump tax cuts. That tax alone would have raised $1.2 trillion in new revenue during the first decade and more during the second decade — a large pot of new funds that would have allowed significant cuts elsewhere in the tax code. That tax was controversial, however, and Trump declared it too complicated. So House Republicans dropped it. Still, old ideas have a way of coming back around in Washington.

There are obvious downsides to such a tax. A national sales tax, which would just be a surcharge on whatever classes of goods Congress choose to tax, would raise prices to consumers and reduce growth— at exactly the wrong time, if in the midst of a recession. A VAT is somewhat different, in that the tax is assessed at various stages of production, which forces producers to bear the cost and pass on as much of it to consumers as they can. Economists consider a VAT more efficient and effective than a simple sales tax, yet in Europe and many other places that have instituted a VAT, it has typically slowed growth because it depresses consumption. “You’d phase it in slowly, and only do it once you’re sure you’re out of the recession,” says Scott.

The best thing, of course, is to keep debt in check when the economy’s solid, as it is now. But that’s not where we’re headed. Frugality is passé.